Borrowers often ask for “Interest Only” (IO) loans b/c they want lower mortgage payments, and we discourage them for a variety of reasons.
I am discussing the pros and cons today.
REASONS TO WANT AN IO LOAN:
- Payment Flexibility: Borrowers with cyclical income want lower payments during slower times (assuming payments really are lower – see below).
- Higher Investment Returns Elsewhere: If borrowers are earning high returns on their money, they often don’t want to sink those funds into their principal balance.
- Want to Pay Off Debts Post-Inflation: Some borrowers do not want to pay down any debts now b/c they are convinced inflation will set in at some point, allowing them to pay off debts later with much more abundant and less valuable dollars.
REASONS WHY WE DISCOURAGE IO LOANS:
- ARMs Only: Most IO loans are only available with Adjustable Rate Mortgages (ARMs), so IO borrowers are not able to lock in historically low fixed rates.
- Harder to Qualify For: IO loans are harder to qualify for, requiring near-perfect credit, ample reserves, low debt ratios and higher down payments.
- Higher Down Payment: This is somewhat redundant to the above item, but most IO loans require at least a 25% down payment.
- Don’t Build Equity: While equity is slow to build at first with all fully amortized loans, after the 5-year mark equity starts to build much faster than most borrowers realize; fully amortized loans are really sort of a forced savings plan that borrowers don’t even realize they are paying into.
- Hard to Find in Post-COVID Era: This is a huge factor right now, as most mortgage lenders don’t even offer IO loans b/c there is no market for them.
- IO LOANS HAVE HIGHER RATES: This is the biggest factor of all. IO loans almost always have much higher rates, eliminating much of the advantage of taking an IO loan in the first place. For a $600,000 loan, for example, a borrower might save $500 per month by taking an IO loan, but her rate could also be 1% higher, costing her an additional $6,000 per year in interest (offsetting the lower payment entirely).
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